Nobel prize justly awarded to pioneers

October 17, 2009

Freedom New Mexico

With all the hoopla over the fellow who was awarded the Nobel Peace Prize, the prize in Economic Science for 2009 has received less attention than usual.

The recipients, Elinor Ostrom of the University of Indiana and Oliver Williamson of the University of California-Berkeley, did pioneering and practical work in understanding how economic and social institutions arise, and how they work best.

Williamson was fascinated by a phenomenon partially explored by 1991 Nobel winner Ronald Coase: Why do large firms develop?

Straight economic theory wouldn’t predict it as inevitable. Coase suggested firms arise when transaction costs are lower inside a firm than in the marketplace at large. Williamson took this insight and elaborated on it, explaining why some firms are vertically integrated, and others focus on a single product or service, leaving other stages of production to suppliers.

“If he had just said, ‘It depends on the circumstances,’ that would hardly have merited a Nobel,” said David Henderson, who teaches economics at the Naval Postgraduate School in Monterey, Calif. “But Williamson explained what kinds of circumstances would lead to particular kinds of firms.”

Take a coal mine and a power plant. If the plant is the mine’s sole customer or the mine is the plant’s only supply source, it is likely the two will merge, creating a vertically integrated firm. If there are several coal mines and several power plants within reasonable distance of one another, however, they will likely remain separate and operate through market transactions.

Elinor (Lin) Ostrom actually got her Ph.D in political science at UCLA before studying problems that economists rooted in theory and mathematics couldn’t explain.

The problem of the “tragedy of the commons” has been widely acknowledged in economics and ecology. When a property is commonly owned — a pasture in a village that is available for all residents to graze their livestock, for example — the incentive for each user is to use it with little or no regard for the needs and desires of others. The resource held in common is likely to be overused and eventually exhausted, so it should either be privatized or regulated by the state.

But Ostrom noticed that in real life things didn’t always work as the theory would predict. Some common resources were exploited and overused, but some were managed rather well. Her research and fieldwork — into irrigation systems, for example — led to a much more sophisticated understanding of resource use, as explained in her 1990 book, “Governing the Commons.”

Bottom line: Resources work best in which all participants have a say in making up the rules — working much better than having an outside force, like the state, make the rules. It’s an example of spontaneous order.

“The important thing about Lin Ostrom,” said 2002 Nobel winner Vernon Smith, “is not that she is the first woman to win the prize but that she richly deserved it. She is a remarkable scholar.”